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Monthly Archives: April 2016

In light of Exxon Mobil’s earnings announcement and continued capital expenditure cuts due to the sinking price of crude oil, I thought it would be a good time to revisit the subject of capex.

Warren Buffett in his 1989 Chairman’s Letter, stated the importance of ongoing re-investment in a business in order for it to continue to grow and remain competitive.

Capital outlays at a business can be skipped, of course, in
any given month, just as a human can skip a day or even a week of
eating. But if the skipping becomes routine and is not made up,
the body weakens and eventually dies. Furthermore, a start-and-
stop feeding policy will over time produce a less healthy
organism, human or corporate, than that produced by a steady
diet. As businessmen, Charlie and I relish having competitors who
are unable to fund capital expenditures.

I’ve heard capital expenditures referred to as the seed corn of future profits and the importance of investing an amount roughly equal to a company’s depreciation on an ongoing basis is vital to the long-term health of that enterprise.

Earnings this year for the S&P 500 are expected to decline approximately 8%, but one way to earn more in a flat or declining revenue year is to curtail the amount of spending necessary to maintain and replace plant and equipment. Short-term decision making that helps the company meet quarterly expectations can ultimately hurt shareholders the long-run.

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Barry Ritholtz haas a great piece on Bloomberg.com about how active management is failing to keep up, much less beat passive management. I’ve often wondered having spent about 20 years trying to produce as much alpha as possible in a short amount of time (AKA trading) if there is less alpha to be created now that everyone has instantaneous access to the same information.

There was a time when having a Bloomberg terminal presented opportunities to make very easy profits just by receiving news before other traders, but since Regulation FD and Yahoo Finance those opportunities no longer exist.

Internet has leveled the playing field: How much information that once was the province of a select few is now in the hands of all?It was a huge game-changer when Yahoo message boards begin to fill up with posts from people doing legwork on individual companies. When someone reported that XYZ Tech’s employee parking lots were filled with cars 24/7 — including weekends — anyone paying attention understood that business was booming and that sales were going to beat investor expectations. For the few who grasped that, this was a period of large trading profits.This advantage exists only when a small number of people know what a large number of people are going to find out too late to act on. When everyone knows, the advantage disappears.

For his take on the reasons why active money management is failing to beat their benchmarks follow the link.

Imagine a bank that pays negative interest. Depositors are actually charged to keep their money in an account. Crazy as it sounds, several of Europe’s central banks have cut key interest rates below zero and kept them there for more than a year. Now Japan is trying it, too. For some, it’s a bid to reinvigorate an economy with other options exhausted. Others want to push foreigners to move their money somewhere else. Either way, it’s an unorthodox choice that has distorted financial markets and triggered warnings that the strategy could backfire. If negative interest rates work, however, they may mark the start of a new era for the world’s central banks.

The Situation

The Bank of Japan surprised markets by adopting negative interest rates in January, more than a year and a half after the European Central Bank became the first major institution of its kind to venture below zero. With other options to stimulate the economy limited, more policy makers are willing to test the technique. They acknowledge that sub-zero rates can crimp the ability of banks to make money or lead them to take additional risks in search of profit. The ECB cut rates again March 10, charging banks 0.4 percent to hold their cash overnight. At the same time, it offered a premium to banks that borrow in order to extend more loans. Sweden also has negative rates,Denmark is using them to protect its currency’s peg to the euro and last year Switzerland moved its deposit rate below zero for the first time since the 1970s. Janet Yellen, the U.S. Federal Reserve chair, said in November that a change in economic circumstances could put negative rates “on the table” in the U.S. Since central banks provide a benchmark for all borrowing costs, negative rates spread to a range of fixed-income securities. By February, more than $7 trillion of government bonds worldwide offered yields below zero. That means investors buying bonds and holding to maturity won’t get all their money back. While most banks have been reluctant to pass on negative rates for fear of losing customers, a few began to charge large depositors.

SOURCE: BLOOMBERG

The Background

Negative interest rates are an act of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored. They punish banks that hoard cash instead ofextending loans to businesses or to weaker lenders. Rates below zero have never been used before in an economy as large as the euro area. While it’s still too early to tell if they will work, ECB President Mario Draghi said in January 2016 that there are “no limits” on what he will do to meet his mandate. Europe’s central bank chose to experiment with negative rates before turning to a bond-buying program like those used in the U.S. and Japan. Policy makers in both Europe and Japan are trying to prevent a slide back into deflation, or a spiral of falling prices that could derail the economic recovery. The euro zone is also grappling with a shortage of credit and unemployment is only slowly receding from its highest level since the currency bloc was formed in 1999.

SOURCE: EUROPEAN CENTRAL BANK

The Argument

In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans. In practice, there’s a risk that the policy might do more harm than good. If banks make more customers pay to hold their money, cash may go under the mattress instead, robbing lenders of a crucial source of funding. But there’s mounting concern that when banks absorb the cost of negative rates themselves, that squeezes the profit margin between their lending and deposit rates, and might make them even less willing to lend. The Bank for International Settlements warned in a March 2016report of “great uncertainty” if rates stay negative for a prolonged period. And if more and more central banks use negative rates as a stimulus tool, there’s concern the policy might ultimately lead to acurrency war of competitive devaluations.

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The holders of the Sequoia Fund are adding insult to injury. The large Valeant Pharmaceuticals position held by the fund can’t be liquidated in an orderly manner so the fund holders who would like to exit are receiving shares of other holdings instead of cash.

Valeant Pharmaceuticals has gone from darling to pariah in less than a year. They’ve finally jettisoned the CEO, but are now facing off with bondholders over a technical default for not filing timely financials.

Investors can learn a great deal from the lesson. Financial engineering, serial acquisitions, and an aggressive management leads to disaster. Throw in a healthy dose of debt to pay for the growth and you have a powder keg ready to explode at the first sign of downturn.

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Yale made 93% a year on venture capital in the past two decades. Warren Buffett is buying entire companies instead of investing in common shares. Are two of the world’s best investors saying something with their actions?